The Dollar Index shifts from a bearish to a bullish trend

Key points:

• A trend-following breakout system triggered a new buy signal for the Dollar Index (DXY) 
• After similar breakouts, the DXY shows a strong tendency to rally further over the following year
• Stocks and energy-related commodities rally while precious metals struggle

A bullish breakout for the Dollar Index (DXY)

A trend-following system for the Dollar Index (DXY) reversed from bearish to bullish, ushering in a new uptrend for the world's reserve currency. The system uses a price channel breakout methodology made famous by Richard Donchian, a pioneer in the managed futures industry. 

After historical testing, I determined that a 133-day high or low breakout provided the optimal timeframe for a Dollar Index (DXY) trading system.

The previous buy signal occurred in August 2021, which led to a substantial gain in the Dollar Index over the subsequent year.

Similar breakout signals preceded positive returns for the Dollar Index

As clearly indicated by the outlook table, currencies typically exhibit a strong tendency to follow the direction of breakout signals. At some point in the first six months, the Dollar Index (DXY) experienced gains in all but one preceding instance. 

Stocks rally when the Dollar Index breaks out

The bullish trend change in the Dollar Index does not mark an unfavorable environment for stocks unless the S&P 500 is in a clearly defined downtrend like 1973 and 2008, which is not the case now.

Signals associated with an FOMC tightening cycle also display positive returns over all time frames. Except for 1973, every precedent showed a positive return at some point in the first three months.

Most sectors and industries show weak results in the first few weeks. Despite a brief lull, the overall outlook for medium and long-term returns is solid. The lackluster returns in Technology suggest companies in that sector, which derive a large percentage of revenues globally, could struggle as an increase in the dollar becomes a headwind.

Keep an eye on energy and avoid precious metals

Should a broad-based commodity index see further gains, bullish trends in energy-related commodities could be the primary contributing factor.

When should we be concerned about the dollar?

When the Dollar Index (DXY) experiences a surge of 10% or more in the preceding 26 weeks, the S&P 500 and sectors tied to commodities tend to react negatively. 

What the research tells us...

The Dollar Index has embarked on a new uptrend based on a trend-following breakout system. After similar trend change signals, the Dollar Index and stocks tend to rally over the subsequent year. The energy group displays the best outlook within the commodity complex, aligning with current trends. Technology, a recent relative winner amongst sectors, could struggle on a go-forward basis, given that the sector derives a significant percentage of revenues from overseas. With the 26-week rate of change for the Dollar Index well below 10%, the DXY shouldn't present an imminent headwind for the S&P 500.